Jamie Whyte is head of research and publishing at Oliver Wyman, a management consulting firm. He is a former lecturer in philosophy at Cambridge University and the author of Bad Thoughts: A Guide to Clear Thinking.

Banks are nothing like 'utilities with casinos attached'

The idea that commercial banks in the UK and America were “utilities with casinos attached” has gained currency. I believe it was John Kay, a columnist at the Financial Times, who coined the expression.

Perhaps rhetorical flourish got the better of him, because an economist such as John Kay should know that investment banks (and the investment banking divisions of “utility” commercial banks) are nothing like casinos. To think they are suggests a failure to appreciate the difference between risk and uncertainty.

An outcome is risky when it is not sure to happen but we know its probability. An outcome is uncertain when we do not even know its probability. That a tossed coin will land heads, or that a spin of the roulette table will land on red, is thus a matter of risk. That property prices will fall by 20 percent and mortgage backed securities will collapse in value is a matter of uncertainty. Whereas casinos deal with risk, banks deal with uncertainty.

The law of large numbers means that businesses, such as casinos, that deal in high-frequency risky events, such as roles of the dice at a craps table, should have very stable earnings. (The law of large numbers states that if the probability of an A being B is n, then, as the number of As approaches infinity, the portion that are B approaches n.) It would take serious statistical incompetence or fraud for a casino to go broke on account of “the roll of the dice”.

If the failed banks – RBS, Northern Rock, Lehman Brother’s and the others – really had operated like casinos, their failure would be almost impossible to explain. Making banks as safe as casinos is the kind of thing that risk managers and financial regulators can only dream of. Disparaging banks' casino capitalism is bizarre.

But it is worse than bizarre. It is dangerous. People who take the metaphor seriously will quickly arrive at the conclusion that bank failures, like casino failures, can only be the result of incompetence or fraud. And the policy proposals that follow from such a diagnosis will be quite unlike those that would follow from the belief that the central problem for the security of banks is uncertainty.

Specifically, the casino-theorists will aim to restrict the actions of market participants, who they believe to be too incompetent or too corrupt to be left to their own devices. But this will reduce the amount of information in the market. And, if uncertainty is the real cause of trouble in banking, eliminating information is the last thing we should want to do.